Realty Income Corporation (O) began with the purchase and leaseback of a single property back in 1969. From there it kept this initial strategy and expanded its footprint with a diversity of tenants. Once it went public in 1994 it gained access to new capital and began to grow quickly and now stands with a market capitalization of $5.62B. Those who invested early in O's development were rewarded with large capital gains and an ever-increasing dividend.
Despite this exceptional performance, I believe Realty Income is presently a weak investment. All of the strengths of the company seem to be priced in, leaving little room for improvement.
Evidence that strengths are priced in
1) A price/FFO of 21 dwarfs the retail sector's average of 16.3. Of course it seems natural that a strong and steady triple net lease company would trade at a higher multiple, such that it maintains similar risk adjusted returns. However, as the multiple gets that high, it really limits shareholder gains even if FFO is entirely returned to them.
2) At $42.72 O trades well above its 200 day moving average of $39.59 and very close to its 52 week high of $42.96. These statistics confirm that the stock price has in fact responded to the company's strong performance and priced it in accordingly.
3) As a triple-net lease REIT with contracts as long as 15-20 years it would be reasonable to argue that the company's value is more than the sum of its assets since the contracts themselves have worth. Once again, this extra value is already priced in as shown by a price/book of 3.06.
Given that the past performance has been accounted for by the market, further gains to investors would need to come from a new source. For an investor, upside comes in the form of either improved company performance, or an increase in the public's esteem of the company, and the associated bump to the stock price. I argue that each of these financially edifying events is unlikely.
To truly fuel FFO growth a company must increase occupancy, rental rates, and/or make accretive acquisitions.
- As of June 30 2012 O had an occupancy rate of 97.3%. This is fairly typical of its occupancy which has mostly ranged between 96% and 100% since it became a REIT. We will not see any significant improvement here as it is already superb.
- In terms of rental rates, O may experience some decreases. This is one of the weakest points of the sale-leaseback strategy as the tenants have strong bargaining power at lease expiry. A Taco Bell building is really designed to be a Taco Bell and significant cap-ex could be required to get a new tenant. To support this point, here is an excerpt from Realty Income's latest 10Q: "During the first six months of 2012, 62 properties with expiring leases were leased to either existing or new tenants. The rent on these leases was $4.7 million, as compared to the previous rent charged on these same properties of $4.8 million."
- With steady occupancy and a questionable outlook on rental rates, only accretive acquisitions remain as an option for bolstering upcoming FFO. O has already made significant acquisitions and a new $1B capacity credit facility suggest more are on the way, but cap-rates are not as high as they used to be. During 2Q12 O acquired 145 properties for $210.8mm at an initial weighted average cap-rate of 7.1% and lease term of 15 years. Given its current weighted average interest rate on debt of 5.85% it seems the spread is fairly narrow, but we will have to see what permanent financing O is able to obtain to fully determine whether these acquisitions have been accretive.
To be clear, I am not suggesting any weakness in Realty Income's cash flows which seem to be healthy and steady, but rather that said cash flows are not enough to justify such a hefty market price. As mentioned above, the other potential source of capital appreciation results from increased pricing due to public esteem.
This too is unlikely, because the investment community seems to already have such a favorable view of the company. Investors will continue to recognize its performance, but should not be fooled by Realty Income's carefully crafted image as a dividend stock. Despite the ample advertising and branding itself as "The Monthly Dividend Company" the dividend is quite average at 4.30% as compared to the sector's average of 4.07%. Those interested in boosting income with a regular dividend may have better luck with other monthly dividend stocks such as Whitestone REIT (WSR) or Gladstone Commercial (GOOD) which provide 8.86% and 8.38% yields respectively. Additionally, these stocks trade at far more conservative FFO multiples.
As the REIT market becomes inflated it becomes increasingly important to distinguish between a good company and a good investment. Realty Income is a great company, but as an investment it falls short of other options currently available. The exceptional performance which has been so beneficial to its investors in the past is the very reason it has become so overvalued. While O is operationally solid, this strength is already priced in and there is simply not enough upside potential to raise its price any further. Realty Income is worth considering for investment, but I am waiting for that FFO multiple to come way down before hopping on board.